Tuesday, June 16, 2009

Retirement, Zvi Bodie Style

Recently, the Wealthy Boomer discussed the investment ideas of Zvi Bodie, a Boston University finance professor (the web page with this article has disappeared since the time of writing). Bodie advocates investing 100% of assets in inflation-protected bonds called Real Return Bonds in Canada and TIPS (Treasury Inflation-Protected Securities) in the US.

These bonds pay a guaranteed rate of return on top of inflation. However, this guaranteed rate is quite low. Bodie uses 2% as a long-term estimate. The attraction is that these bonds are very safe even from inflation.

Bodie uses the example of saving 100 kopecks per year for 40 years, and then withdrawing an inflation-adjusted 280 kopecks per year for 30 years of retirement. All this comes with no worries about stock returns or inflation.

This sounds appealing, but it’s worth looking a little closer. To save for 40 years before retiring at age 65 means saving starting at age 25. I’m all for starting to save for retirement early, but realistically, few people start saving serious amounts for retirement at age 25.

Instead of talking about kopecks, let’s try dollars. Let’s say that a 35-year old worker Wanda saves $5000 per year (after tax) in a Tax-Free Savings account (TFSA). We’ll assume that Wanda does this for 30 years and that the amount saved each year rises with inflation.

Wanda never touches this retirement money for 30 years and earns 2% above inflation each year. How much can she withdraw each year for 30 years starting age 65? The answer is an inflation-adjusted $9200 per year. If this doesn’t sound very good to you, then I agree. Between this and the Canada Pension Plan, Wanda probably has enough for rent and food, but not much else.

What if Wanda rolled the dice and invested in a mixture of stocks and bonds and earned average compound returns of 5% over inflation? In this case she’d be able to withdraw over $22,000 per year for 30 years.

Of course there is no guarantee that anyone would average 5% over inflation. Wanda might instead have better or worse returns. To avoid this risk, she could just resign herself to the guaranteed $9200 per year, but this isn’t very appealing either.

The truth is that most people won’t manage to save even $5000 after tax each year for their retirement. They are faced with the choice of a guaranteed pittance each year during retirement using Bodie’s plan, or rolling the dice with riskier investments. My personal choice is to roll the dice.

11 comments:

  1. I guess one could compute the probability that stocks would underperform inflation-adjusted bonds over a given duration. I'd guess the probability would become negligible around the 25-year mark.

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  2. Patrick: It's true that the odds of underperforming real return bonds drops as time horizon lengths. I've read much of what Bodie has to say and he seems unimpressed by such probability calculations. He says that as long as there is a chance of losing money, he's not interested in risk. For someone like himself with a nice income, this means that he chooses a safe and comfortable retirement that won't permit excesses. For most people whose income is much lower his advice amounts to "better cat food than no food".

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  3. It does seem rather extreme to want to put all your savings in real return bonds, expecially early in your working life when you don't have much to lose and you can adjust to stock market losses by saving more and/or working longer.

    I suppose if you've saved enough and can meet your retirement needs and desires through the yield on real return bonds, then I suppose there is not much to gain from gambling with the stock market.

    However that doesn't apply to most of us. Even the most risk adverse should probably have some savings in the stock market.

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  4. Maybe there is no right answer. It depends on each person's appetite for risk. Stocks are most likely to provide better returns according to history but there is no guarantee they will do so over the particular 20- to 30-year period an investor begins their saving for retirement.

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  5. Larry: You're right that there is no single answer that is right for everyone. My contention is that a portfolio of 100% real return bonds would not work out well for the majority of people.

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  6. I wouldn't have expected such a stance from a finance professor. I think I'll skip his class.

    I didn't read the linked article, but it seems that if one is worried about inflation, one should buy stock in companies that contribute to inflation. Worried about the price of gas, buy some Exxon. Worried about food prices, buy fertilizer companies and Kraft, etc. Better yet, try to find companies that can increase prices faster than inflation. They have a durable competitive advantage.

    As an aside, I heard a guy on a podcast saying that postage inflation is higher than CPI inflation, so he jokingly advised buying the "permanent" stamps that the US Postal Service offers, instead of TIPS for inflation protection.

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  7. I believe you have mischaracterized Zvi Bodie's approach to personal financial planning. Here is Zvi Bodie's six step approach for asset allocation from his book, Worry-Free Investing.

    1. Set goals.
    Make a list of the specific goals you want to achieve through your saving and investment plan. For example, “I want to continue to live at my customary standard of living after I retire”.

    2. Specify targets.
    Determine the amount of money you will need to achieve each goal. These amounts become the targets of your plan. The very definition of risky or safe investing will depend on the target. TIPS and I Bonds have substantially lowered risk if the goal is retirement, but for college saving, special tuition-linked accounts are safer.

    3. Compute your required no-risk saving rate.
    Figure out how much you need to save as a fraction of your earnings on the assumption that you take no investment risk. For many people, it is appropriate to count your house as a retirement asset.

    4. Determine your tolerance for risk.
    Using as your benchmark the lowered-risk plan you have created in Steps 1–3, evaluate how much risk you are willing to take. Your capacity to tolerate investment risk should be related to the riskiness of your projected future earnings and your ability and willingness to postpone retirement if necessary. The safer your job and your future earnings, the greater your tolerance for risk in your investments. The more willing you are to postpone retirement if your risky investments perform badly, the greater your tolerance for risk.

    5. Choose your risky asset portfolio.
    After deciding how much of your wealth you are willing to put at risk, choose a form for taking the risk that gives you the greatest expected gain in welfare.

    6. Minimize taxes and transaction costs.
    Make sure that you are not paying any more in taxes, fees, or other investment costs than is necessary.

    What Bodie has said (that is close to your chararterization) is that individuals within 10 years of their target retirement year should be taking very little investment risk and should seriously consider being 100% invested in TIPS and other very safe assets such as I bonds.

    As an aside by law postage stamp price increases cannot exceed CPI increases. Since the forever stamp was introduced, postage stamp price increases have always been below CPI price increases. Hardly a surprise given the legal constraint.

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  8. Anonymous: This list of steps gives no answer for most people. What happens when a 30-year old determines that using inflation-protected bonds his needs in retirement require that he save three time more than he is able to save? Bodie gives no answer for this other than to lower expectations. Bodie's idea of building your own principal-protected note with bonds and call options is little better because the upside is severely blunted compared to stock ownership. Bodie's advice works wonderfully for people who earn triple the median income, but not so well for the thundering herd who are closer to the median.

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  9. Bodie is most certainly not saying that individuals under the age of 55 should not be investing in risky assets. He is saying that when determining how much of your portfolio to devote to stocks you should take account how risky your future labor earnings are, how many years you are willing to postpone the beginning of retirement if your risky assets perform very poorly, and/or how much you are willing to raise your pre-retirement savings rate if your risky assets perform very poorly.

    Bodie also believes you should decide on a minimum level of acceptable retirement income, as well as a higher targeted income level, and that the lower minimum level should be funded by relatively safe assets in the pre-retirement portfolio. How much risk to take in the remainder of the portfolio depends on the riskiness of your labor income, your willingness to postpone retirement and raise your savings rate if risky investments perform poorly, and how risk adverse you are to accepting a very low living standard in retirement.

    A 45 year old who thinks he can solve his retirement funding problem by increasing is equity allocation from 55% to 80%, while keeping both his savings rate and retirement target year constant, is running a fool’s errand.

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  10. Anonymous: Again, this advice is wonderful for people with huge amounts of disposable income, but not much help for average people. What happens if I figure out the saving rate I need to fund a minimum acceptable lifestyle at retirement, but find that this saving rate is triple what I'm currently saving? There is no excess over the minimum acceptable amount to put into risky assets. Your hypothetical 45-year old may be looking at retiring at age 78 with low-risk investments or retiring somewhere between age 62 and never with riskier investments. I wouldn't call it a fool's errand to try the riskier path.

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  11. I think Bodie is absolutely right when he says that financial advisors often ask "How much do you want in retirement" instead of asking people to look at their goals in the context of their current lifestyle. The problem that people run into is thinking that they can live better in retirement than when they were working, and then take on excessive risk to do so. How much Bodie earns relative to other people is unimportant. It's precisely this type of comparison that gets people into trouble with unrealistic notions of what they deserve in retirement. He basically says you get what you set aside, plus a little extra.

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